Cutting Costs Without Drawing Blood

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In looking for ways to cut costs—something most companies still need to do despite the good economic times—most managers reach for the head-count hatchet. There’s good reason: the markets usually roar with approval. When Eastman Kodak, for example, announced three years ago that it would lay off 10,000 people, saving an annual $400 million in payroll, its market capitalization rose by $2 billion within a few days. Similar stories have played out hundreds of times in the past decade.

But cutting costs doesn’t have to be such a bloody process. In my consulting experience over the past 13 years with more than 200 companies in varied industries, I have seen compelling evidence that a company can almost always create far more sustainable value by sensibly reducing its capital expenditures. How? Not by postponing or eliminating big spending projects, which are usually less than 20% of the budget anyway, but by conducting a rigorous, disciplined evaluation of the small-ticket items that usually get rubber-stamped. Those “little” requests often prove to be unnecessary—in some cases they duplicate other requests—or gold plated. But few managers have the time, energy, or inclination to ask about them. They should.

A solid evaluation of small-ticket capital budget items is straightforward. It involves a series of only eight questions, and the payoff is enormous. Cutting the capital budget increases cash flow dramatically, which can have an enormous impact on a company’s value in the marketplace. In fact, according to my research, a permanent 15% cut in the planned level of capital spending could boost some companies’ market capitalizations by as much as 30%. Better still, the company gets to keep the heads—make that brains—that might have been fired. Paying more attention to small items in the capital budget creates that business rarity—a win-win situation. (For more on the advantages of cutting capital spending, see the table “Capex Dollars Versus Job Dollars.”)

Capex Dollars Versus Job Dollars

You get more bang for the buck—or perhaps more buck for the bang—by cutting capex dollars than by cutting payroll. According to my estimates, the increased market valuation that resulted from Kodak’s $400 million payroll cuts could have been achieved by a $280 million reduction in capital spending. The reason for the difference, of course, is that a company has to make severance payments—$600 million in Kodak’s case—to people it has laid off. (There is no severance pay for capital.) The table compares recent payroll savings at Kodak and several other corporations with my estimated value-equivalent capex cuts.

But the eight questions don’t get asked all at once. They should come in three distinct phases:

Put the first three to your operating managers as they assemble their capital project requests. The questions will help them submit airtight proposals.

Put the next three to yourself and your colleagues as you examine the small-ticket proposals. The questions will help you root out much of the gold plating and redundancy built into budget requests.

Pose the last two questions at the end of the process. They will help you improve it for the next time.

When did you last go to the trouble of asking these questions about a decision involving less than $5 million?

In this article, we’ll look in detail at each phase and its questions. None of the questions, to be sure, will sound wildly unfamiliar. But when did you last go to the trouble of asking such questions about a decision involving less than $5 million? The answer may be “Never,” which likely means you’ve been spending more than you should have.

Why Small Requests Go Wrong

Before we look at the questions, it’s useful to understand why small-item budget requests are often such a source of waste. The root of the problem is that senior managers with very limited time at their disposal usually feel they can best serve the company by focusing on big-ticket investments. That’s not to say that focusing on big-ticket items is wrong—those investments often have huge strategic importance—but one result is that senior managers end up rubber-stamping the small proposals that often make up the remaining 80% of the capital budget.

Senior managers end up rubber-stamping the small proposals that often make up 80% of the capital budget.

Rubber-stamping, however, causes problems because the people preparing small-item capital spending proposals typically lack the experience or knowledge to think them through properly. And for a variety of reasons, unit managers will almost inevitably ask for more money than they need. Those reasons can be all too human. Many of the people who generate small-item spending requests are engineers. With the best intentions, engineers often indulge in gold plating. That’s a natural by-product of their sensibilities—engineers generally value reliability, redundancy, and technical bells and whistles. Given a choice, they will include top-of-the-line supplies and equipment in their projects.

But it’s not just engineers. Anyone at a middle or low level in an organization is likely to be risk averse, which causes overspending. No frontline manager wants to be blamed for having ordered too few spare parts when a crucial piece of machinery breaks down and creates a product shortage. Overspending may also result from unit managers’ attempts to protect their turf—a low budget request this year may lead to the unit being short-changed the next.

Finally, a lot of overspending on small items is the result of a perfectly understandable dynamic. Managers on the front line have a natural tendency—even a duty—to focus on their own units’ needs rather than on whether their requests overlap with those of other units. And as we’ll see, some duplication may be a consequence of processes and measures put in place by senior managers. In such cases, senior managers who fail to keep an eye on small-item capital spending have only themselves to blame.

Let’s turn to what senior managers can do to root out the waste—the eight questions they can ask during the budgeting cycle. First, let’s examine the three questions that can help get the budget process off to a better start. (For a visual explanation of the questions, see the exhibit “Bringing Discipline to Capital Budgets at AnyCorp.”)

Bringing Discipline to Capital Budgets at AnyCorp Eight questions and a postmortem can help senior executives conduct a solid evaluation of small-ticket capital budget items. Cutting the capital budget increases cash flow, which can have a huge impact on a company’s value in the marketplace.

Requesting the Right Information

As all Bostonians know, there’s no one right way to make New England clam chowder. But whatever the details of the recipe, cooks will always need clams, milk, and potatoes. It’s much the same with capital spending. There are three questions that should always be part of the mix when unit managers are cooking up a proposal:

Is this your investment to make?

Sometimes a unit manager will overstep the boundaries of his control and put in a request for an investment that is the responsibility of someone else in the company—or even of some other organization altogether. That happened at one manufacturer: the sales and marketing group had requested money to buy shares in the company’s dealers. The dealers, according to the sales and marketing people, would use the capital to upgrade their facilities and infrastructure. “If you must assist your dealers in upgrading their facilities,” I said to the company’s managers, “why not provide a financing program for them instead? After all, the storefronts are theirs, not yours.” By forcing unit managers to explain why they, rather than others, need to make particular investments, senior managers can head off a lot of unnecessary spending.

Does it really have to be new?

If they could afford it, most people would like to drive a new car. Managers are no different. They instinctively justify buying new machines on the grounds that the old ones need a lot of maintenance. But in my experience, that argument is deeply flawed. Equipment manufacturers in one industry I’ve studied, for example, routinely spend millions of dollars on new machines years earlier than they need to. In most cases, the overall cost (including the cost of breakdowns) is 30% to 40% lower if a company continues servicing an existing machine for five more years instead of buying a new one. In order to fight impulsive acquisitions of new machinery, companies should require unit managers to run the numbers on all alternative investment options open to them—including maintaining the existing assets or buying used ones. Time after time, managers will go no further than an analysis of the economics of purchasing the new machine. But even if those economics are sound, there’s usually a cheaper alternative to buying new.

How are our competitors meeting compliance needs?

Managers who must make investments to comply with environmental, health, and safety regulations tend to be afraid they’ll be blamed for underspending if something goes wrong. This sometimes irrational fear prevents them from thinking as clearly or imaginatively as they should about how to save money on compliance, so they gold plate their investment requests. But a company should plan such expenses with the same rigor it brings to its tax obligations. A good way to combat conservative and costly compliance is to require unit managers to compare their proposals with the practices of other companies.

Reviewing the Budget Proposals

Although senior managers can avoid a lot of misspending by getting people to submit the right kind of proposals, some padding invariably gets through. Asking the following three questions during the proposal review helps uncover the fat:

Is the left hand duplicating investments already made by the right?

Banks, telephone companies, and other big, far-flung organizations with complicated operations have a tendency to accumulate excess capacity. That’s because many different groups of people are involved in the planning and implementation of capital expenditures. The scale of the problem can be impressive. A certain network company, for example, discovered in the course of a spending review that it had inadvertently created a 70% excess capacity in its server network. The company’s field engineers, unaware that the people designing the network had built in a 30% extra server capacity, installed so many additional servers to ensure availability that excess capacity was more than doubled. In order to expose this kind of unnecessary spending, managers need to check how well the various decision-makers involved with a particular item are communicating with one another as they pass the item down the line. If there’s no regular, honest exchange of information, there’s a high chance the company is spending a lot on unnecessary capacity.

Are the trade-offs between profits and capital spending well understood?

In some companies, no amount of prior consideration will stop managers from sending in requests for new assets. In such cases, it usually turns out that the company suffers from a financial culture that places earnings above all other performance measures. Take the example of a certain telecommunications company. Its network designers insisted on using extra thick telegraph poles and specified that they be placed five feet closer together than required by law. Such a distribution system, they declared, would be better able to withstand falling tree limbs during storms. Asked why the company didn’t trim the trees instead, the engineers replied that the cost of trimming would reduce the company’s profitability, while the extra capital investment would not, since it wouldn’t appear in the earnings statement! Our analysis, which capitalized the after-tax cost of the extra annual maintenance so that it could be compared with the capital cost of the distribution system, showed that the stronger distribution system was several times more expensive.

Are there signs of budget massage?

Budget massaging is common at large companies where senior managers don’t police capital spending beyond looking to see whether a unit’s spending matches its forecasts. In such companies, unit managers may be reluctant to propose reductions in their capital spending because they are afraid the head office won’t be generous when they need an increase; on the other hand, they may be afraid that asking for too much money will provoke a close encounter with the company’s internal auditors. So they may attempt to massage the budget in a couple of ways. One is to shuffle expenditures between capital and annual operating budgets so that the capital budget never shows a dramatic change from year to year. Another is to practice year-end loading—when managers realize they’re going to underspend the allocations they’ve requested, they start putting in unnecessary expenses to make up the shortfall. A dented fender, for example, becomes an excuse to request a new pickup truck. By going to the trouble during the year to query unit managers about small decisions of this sort, senior managers can discourage units from massaging their budgets.

Revisit Business Processes

After the unit managers have gone off to spend their money, senior managers should look again at the procedures that have been set up to improve the efficiency of the company’s spending and make sure they are working. The next two questions can uncover many problems:

Are we using shared assets fully?

At networked businesses that use a lot of shared assets—car-rental companies, airlines, electric utilities, telecoms, Internet service providers, and the like—spending is highly sensitive to slow-moving bureaucratic procedures. A certain telecommunications company, for example, was investing millions in new servers, even though its network wasn’t growing quickly enough to justify the new equipment. The reason, it turned out, was that the official procedure for disconnecting and relocating unneeded servers took so long that they didn’t show up as excess on capacity lists until the year after they were deemed unnecessary. The best way for a senior manager to find out if this sort of thing is going on is to check the extent to which shared assets are really being utilized—and not just by looking at extra-capacity lists. If shared assets are not fully utilized most of the time, it’s likely you will have to revisit your company’s paper trails.

How fine-grained are our capacity measures?

Not all bureaucracy-induced overspending is a result of slow procedures. Sometimes, overspending is a direct consequence of a company’s measures for recognizing that it needs more investment in equipment. If such measures aren’t adequately fine-grained, managers can underestimate the capacity of equipment or networks. This happened at a cable company whose capacity measures indicated that a bundle of optical fibers was being fully used if just one fiber was carrying information. But each bundle consisted of 11 fibers; since there were three bundles per cable, a line with 33 fibers could be classified as fully utilized if as few as three fibers were lit. Naturally, the company installed far more cable than it needed.

Conducting a Postmortem

When all is said and done, even the most careful budgeting process is fallible. What’s more, in a fast-paced marketplace like the Internet you can lose out by taking time to probe deeply as you make decisions on capital spending. That’s why managers need to supplement budget supervision with regular audits of units’ capital spending. There are three rules to follow in conducting such inquiries:

Be inclusive.

Many companies leave their audits to people in the finance department, who often confront workers in an adversarial manner. That’s wrong. Audit teams should always include employees from the departments being reviewed. For a company to unearth the kind of overspending I’ve been talking about, it’s essential that the people who know most about the operations buy into the process. At the same time, the team needs to have some organizational authority. It is, after all, going to be asking embarrassing questions. The team should therefore report to a senior executive who has the muscle to clear obstacles from its path and make any changes it may recommend.

Have a clear goal.

The audit team should not only identify what went wrong with last year’s budget, it should come up with recommendations for change. A good audit should specify ways to save at least 10% of a unit’s capital budget. If senior managers want to stretch a team, however, they should set a higher goal of 15% or 20%.

Group small items together.

The really big savings come when senior managers discover systematic problems with whole classes of expenditures. It’s easier to find such problems if you look at all the requests for particular items—transformers at an electric utility or clamps on a pipeline, for example—at the same time. I remember an executive of a chemical company—he was blind—who had his staff construct a detailed scale model of a new chemical plant; having reviewed the design in three dimensions, he reduced the cost of the plant 10% by rerouting pipes to save on expensive elbow joints.

A good audit can turn up surprising horrors. One of my favorite stories is about a telecommunications company I was advising eight years ago. In the course of reviewing the company’s capital spending, I came across an internal rule specifying that all cables be laid at a depth of two meters. I asked the head of engineering about it, and he said that at two meters, the cable network would be protected against a thermonuclear magnetic impulse created by the explosion of a hydrogen bomb. “Fair enough,” I replied, “but what happens to your customers when the bomb goes off?” The company saved $80 million a year by reducing its cable depth to one meter. If you make the eight questions and an audit a part of your company’s small-item capital budgeting process, you may well find a lot of buried treasure.

Tom Copeland (tom_copeland@monitor.com) is the managing director of corporate finance at the Monitor Group, a consulting firm based in Cambridge, Massachusetts, and is the author, with V. Antikarov, of Real Options: A Practitioner’s Guide (Thomson, 2003).

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